No. 292 - Wage Indexation Bargaining and Inflation

Price versus productivity indexing is considered in a model of monetary policy with wage bargaining. The wage-indexing rule is negotiated in a first stage of the game between government, union and firm. In a perfectly price-indexed economy, the government has no temptation to create unexpected inflation and the inflationary bias associated with the credibility problem is completely eliminated. On the other hand, productivity indexing is more appropriate to dampen macroeconomic fluctuations when real disturbances are the causes. We show that productivity indexing alone guarantees both price and employment stability, provided the government's reputation is good enough and the union's bargaining power is not too high. This in turn implies that the equilibrium degree of price-indexation decreases as the union gets weaker and the government's reputation improves. Productivity indexing generally increases with highly volatile productivity processes and relatively weak unions.